Investors are individuals, with unique personal and economic requirements and profiles, which affect their need for cash and their risk tolerance. Since every investment vehicle has its own characteristics, such as earnings, dividends, growth potential, volatility, safety, and the like; it should be possible, in principle, to construct a portfolio that is tailored to any given individual investor's needs. The problem investors face is to find some rational, systematic method of selecting this portfolio from the plurality of investment vehicle classes and the virtually endless individual investment vehicles available.
Historically, investment choices have been difficult for the typical individual investor, particularly in that investors typically wish to invest in a number of different investment vehicles for purposes of diversification but have a limited amount of funds to invest. The problem is exacerbated by the fact that most individual investors have neither the understanding nor the resources to properly gauge the risk of and prospective return on investments.
If investment in stocks is taken as illustrative of the general problem posed above, the advent of stock mutual funds in recent years has made it substantially easier for individual investors to achieve the goal of diversification on a limited budget. However, here, too, the proliferation of mutual funds and the broad range of mutual fund types and categories, again leaves the individual investors with the daunting task of evaluating and comparing the various funds available for investment, particularly from the standpoint of return and risk, in light of their personal investment profiles.
Accordingly, a readily understandable method for appropriately evaluating the returns and risks of individual investment portfolios would be exceedingly desirable for individual investors.
To proceed further, the meaning of two key concepts need be clarified: risk and volatility. They are often used interchangeably, although they differ significantly.
“Risk” indicates a possibility of an undesirable event or outcome and further implies the possibility of loss. Investment risk is thus characterized as a strictly downside concept. On the other hand, “volatility” is a measure of the variability of results in either direction, both upside and downside. While it appears that theses two concepts are related, the exact nature of the relationship between them is not simple.
As is known to those familiar with the art, there are two primary approaches to looking at investment risk:
1. Modern Portfolio Theory (MPT) of Markovitz bases the measure of risk on the volatility of return on investment, which is defined as the statistically evaluated standard deviation of the return. In particular, the notion of β is introduced, which is defined as the volatility of an individual security relative to that of some predefined measure such as well-diversified portfolio (e.g., the Standard and Poor's 500 Index, the Russell 2000 index) or some other broad based index.2. The approach developed by Morningstar Inc, a financial publishing service, bases the measure of risk on shortfall of performance of a mutual fund by comparing return to that of three-month Treasury Bill as a baseline or standard. The relative shortfall is calculated on a monthly basis for the period, typically three or five years, being analyzed, with only shortfalls or negative results being taken into account. The monthly results are averaged to provide a risk statistic for the fund.
Both approaches suffer from a number of limitations, most notably in both cases that they are not readily understandable by the typical individual investor.
Different measures of comparison of portfolio performance have been proposed based on the above two approaches; such as the indexes of Sharpe, Treynor, Jensen, etc. These indexes however, in addition to their technical limitations, in each case suffer from the shortcomings of the risk measure used.
An approach that has been used for evaluating portfolios has been Mean Variance Portfolio Theory of Markovitz, wherein a good portfolio is a portfolio which has maximum expected return E(r), which is the measure of the reward for the portfolio, and minimum standard deviation of return Std(r), which is the measure of risk for the portfolio. This definition leads to the obvious procedure to find set of portfolios for which we have maximum E(r) and minimum Std(r) simultaneously. These are called “efficient portfolios” and asset of such portfolios constitute so called “efficient frontier.” According to this methodology investor should somehow choose his portfolio from the set of “efficient portfolios.” This approach, which is mathematically indisputable, leaves the investor with an ambiguous decision tool. The investor is expected to somehow map his investment priorities to the Markovitz proposed measurements of risk and reward, or at least compare different investment options according to the Markovitz criteria in order to decide which is better.
U.S. Pat. No. 5,784,696 to Melnikoff, included herein by reference, discloses “Methods and apparatus for evaluating portfolios based on investinent risk” or more specifically, based on risk and risk-adjusted return of investments. In the Background of the Invention section, Melnikoff provides more detailed explanations of the basis and the limitations of the MPT and Morningstar approaches mentioned hereinabove. He then contends to teach an iterative method for an investor to select an investment portfolio from a library of assets by evaluating risk-adjusted portfolio performance, including some accounting of investment costs, taxes, and the investor's risk aversion. However, he uses a non-standard approach to risk and evaluation that does meet his goal of understandability to the individual investor.
U.S. Pat. No. 6,021,397 to Jones et al. discloses a “Financial advisory system” with similar goals that simulates returns of a plurality of asset classes and financial products in order to produce optimized portfolios. Attempt is made to take into account constraints on the set of financial products available to the individual investor, as well as the investor's financial goals and risk aversion. Here, too, risk is defined in a non-standard and non-intuitive way that does not provide the individual investor with clear or unambiguous means for making investment decisions.